Equity – Page 15

Dorel will have a lot of cash leftover

Dorel announced the unloading of its sport division today for US$810 million.

This company was trading for less than CAD$2/share during the pits of Covid-19 and made its way back up to $16 (management attempted to go private at this price) before sliding down again to $10.42 on the last Friday close.

I have held the company in the past, although it was one of the ones that I jettisoned during Covid in favour of others (which turned out to be a mistake, but c’est la vie).

My chief complaint about this company was that the entrenchment of management and their very large compensation was a bit off-putting. The business itself is quite diversified, one level up from retail on the value chain – still very low margin and they probably will be facing significant cost and logistical pressures with all of the supply chain anarchy going on.

After they conclude their sports division sale, however, they’re going to have a lot more cash to deal with. If you zero out their debt and cash, and the added proceeds of US$810 million from this sale, you are left with about US$446 million net cash at the end of the day.

On 32.5 million shares outstanding, that’s about CAD$17/share in cash alone.

The company will have a capital gains tax bill to pay off as a result of this transaction, but it still will be in a strongly cash positive position, which means it is most likely they will give out one huge special dividend when this is over with.

It will be interesting to see how this stock will trade on Tuesday morning – undoubtedly it will be higher, but how much?

Teck / Metallurgical Coal

The rumour mill has Teck (TSX: TECK.B) looking at selling or spinning off their metallurgical coal unit for $8 billion.

In the 3 months ended June 30, Teck’s metallurgical coal unit did $1.1 billion in revenues and generated $191 million in profit.

However, since June 30, metallurgical coal prices have exploded. Teck is going to be making a lot more money from this unit in the near term future. Hard coking coal, shipped to China, is nearing US$500/ton. Domestic is approaching US$300/ton.

Realized sales in Q2 was US$144/ton with 6.2 million tons sold. Costs were $64/ton plus $42/ton for transport (moving 6.2 million tons of anything, let alone across the Pacific Ocean is going to be expensive).

While the coal volume will drop slightly in Q3 (due to BC wildfires and such), the realized price is going to increase dramatically, especially with Teck having two points of egress (they are no longer hamstrung by having Westshore Terminals (TSX: WTE) being their only exit point for coal).

If Teck manages to get $8 billion out of this unit, they will be able to eliminate their debt and become that much closer to being a pure copper play.

I also thought they were going to get rid of their energy division, but clearly management is waiting for higher prices before pulling the trigger on that (likely in the form of a sale back to Suncor of its division).

This would be an interesting turnaround for Teck – their coal division was primarily acquired through the Fording River acquisition in July of 2008, and they paid US$14 billion for them, with the lion’s share (US$12.5 billion) in cash.

We all know what happened in late 2008 – the economic crisis really hit the fan. The acquisition was possibly the worst-time acquisition in Teck’s corporate history and it nearly bankrupted them.

So now we fast-forward 13 years later, and Teck is looking at getting rid of their coal division.

My question is – who would buy this? There’s no logical strategic buyer for the entity. Financially, perhaps some hedge funds want to make a gamble that coal pricing will be excessively high for a longer duration of time than the markets anticipate. One financial combination that would make some sort of faint sense is one of the British Columbia crown corporation pension plans (think about the regulatory protection that would afford the company), but one could imagine the political outrage of taking over a coal company in the era of climate change consciousness.

A spinout would be more likely, but I would see the Teck umbrella affording the coal entity much more regulatory protection than being a standalone entity.

As such, I do not believe they will take any real action on the coal entity. I could be wrong.

If they were able to dispose of the coal unit on acceptable terms, the financial engineering motive is pretty simple – by being seen as a more pure copper play, the company would receive a higher valuation. I know how my cautious investing colleague John Cole is feeling about Teck, but this commodity cycle is not at the point of peaking yet. Unlike lumber (where starting up and shutting down is a way of life and can be done with relatively quick frequency), other commodities have much longer cycles and activating coal/copper supplies is a matter of years and not months.

The other observation is that Teck is exporting 6 million tons a quarter, Arch (NYSE: ARCH) is going to do about 2.5 million tons of met coal a quarter now that Leer South is opened. While Arch has a geographical disadvantage (more difficult to ship the material to China from West Virginia), ton-for-ton would give them a US$2.6 billion valuation, which is about 60% higher than their current stock price, accounting for the moronic convertible debt financing they did a year back.

Short note – Coal

Market pricing for metallurgical coal is going nuts in China – right now it is north of US$400/ton cfr (and given how gong-showed marine transportation logistics are these days, freight is not a trivial expense). However, the point is that even with freight these are very, very, very high prices. This has impact on prices that Teck will receive on their met coal production (a good chunk of their met coal production goes over the Pacific). In addition, my briefing note and financial forecast I wrote on Arch Resources in June (cash generation of $15-20/share) is looking increasingly conservative.

In the current commodity price environment, both Teck and Arch will be cash machines. While both companies aren’t going to make US$400/ton on all of their sales (the North American market is much less pricier), the overall impact on pricing across the geographical spectrum is clearly up from where it was 18 months ago.

Teck will also have the supplement of its 70% owned QB2 project when it is completed in 2022. QB2, at US$4.00/pound of copper, will generate about US$1.7 billion EBITDA on a 100% basis and after baking in 40% taxes, Teck should be able to generate an incremental US$700 million/year in cash out of this project. Every 50 cents of copper above this will be about US$125 million more. On a consolidated company basis, it is foreseeable they will be able to pull in about $3 billion a year in cash. Once the capex on QB2 is finished (which is the primary cash drain for Teck at the moment), they will be able to begin a simultaneous debt paydown and dividend increase at the same time – my guess is they will ramp up their existing $0.05/quarter dividend to around $0.25/quarter once QB2 is finished and dump the rest into debt repayment. My guess is they’ll want to get below at least $5 billion net debt.

Arch’s net debt probably peaked out at Q2-2021 and at this point forward, it will be generating significant sums of cash. When examining coking coal statistics, the Leer South mine (pretty much finished) will be positioned to grabbing the lion’s share of this market. It takes years to get a coal project out of the ground and mal-investment has finally taken its course. In 2022 they will likely be able to pay off their net debt and then re-institute a dividend or share buyback (offsetting their near-disastrous capital allocation decisions of previous years post-Chapter 11).

The virtual investment prohibition (fueled by ESG and other environmentalism) has created an environment of impossible-to-get capital for coal projects – a perfect formula for elevated prices for those that have incumbency rights. Both Teck and Arch fit the bill for metallurgical coal in North America.

The question is when the party will end. As long as worldwide demand for steel remains red-hot, not anytime soon.

Cervus Equipment buyout – takeover price undervalued

It has been an exciting 2021 with my third company getting receiving a takeover solicitation. Cervus Equipment (TSX: CERV) announced it was being acquired by Brandt Tractor for CAD$19.50/share in cash.

This is still a dirt cheap valuation.

Not surprisingly, they want to close the deal pretty quickly:

Cervus expects to hold the Special Meeting of shareholders to consider the Transaction in October 2021 and to mail the management information circular for the Special Meeting in September 2021. Subject to the conditions set forth above, the Transaction is expected to close in the fourth quarter of 2021.

A two-thirds vote is required, with the chair holding 18% of the stock, coupled with Brandt holding another 9%. Unless if there is some organized opposition to this deal, it looks like it is going to proceed.

The price that is being paid is cheap. CERV has 15.4 million shares outstanding and from the first half alone has generated about $1/share in earnings. Cash-wise, in the first half they have generated about $23 million (about $1.5/share) in free cash. Full-year, they’re probably going to pull in something around $2.50-$3.00/share. Balance sheet-wise, they are at around $40 million net cash, and approximately $13/share in tangible book value, or $16.85 if you include the intangibles and goodwill. Brandt is paying a slight premium over the balance sheet value, but given the earnings power of the company, they are getting a very good price. It is too good a price.

A fair deal would be around $23-24 in my estimation, but who am I to say?

There is some precedent for a small boost up in price – Rocky Mountain Equipment (formerly TSX: RME) was taken over in the middle of the Covid crisis last year for what could be considered a total steal of a price. The original all-cash $7.00 management takeover was boosted to an all-cash $7.41.

In a final slap in the face, the following:

Pursuant to the Arrangement Agreement, the Company has agreed not to declare or pay any common share dividends until the completion or termination of the Transaction.

That said, overall, if the deal goes through at the $19.50 price, I would have made around a 150% gain on this over a year. It was a small position (obviously should have been larger, but the liquidity was awful and there was other stuff on my radar at the time), but just like most good trades, you always wish you took more of it.

I’ll be voting against the deal if I still have my shares. The price of $19.29 presently is a 21 cent merger arbitrage on an October closing and at 6.5% annualized, I’ll hold and hope that there is a minor increase in the takeover price. Other than the Chairman, the greater than 5% owners holding this, at least according to TIKR, are Invesco Canada (7.3%), Burgundy Asset Management (7.2%), Fidelity (6.6%) and Van Berkom (5.8%). They will have to get together to extract another few dollars out of this thing before it delists.

Unlike Atlantic Power and its convoluted capital structure, I have no fears that this deal won’t be closing. At worst, it’ll be cashed out at $19.50/share in October and the capital will go to another happy home.

Ag Growth – Ag Shrink!

Ag Growth (TSX: AFN) used to be my largest portfolio component, but by virtue of depreciation and something else in the top 5 that has appreciated, is no longer. The company’s stock has taken a beating over the past 3 months:

The market was spooked by their Q1 (May 2021) announcement on their conference call regarding the pricing of steel (indeed, when looking at Stelco (TSX: STLC) you can see what they mean) – companies quote projects and their quotations typically remain open for 30 days, but this is like giving your customers a free one month call option on steel pricing, so they had to tighten this up. They said the high-cost backlog would cost them some margin in Q2 and Q3 but it would normalize in Q4 onwards.

In Q2, there was some margin degradation, and besides this, the quarter was reasonably decent. Sales up, gross profits up, margins slightly lower but this was to be expected. However, the killer payload was this line:

In 2021, two legal claims related to the bin collapse were initiated against the Company for a cumulative amount in excess of $190 million, one of which was received subsequent to the quarter ended June 30, 2021. The investigation into the cause of and responsibility for the collapse remains ongoing. The Company is in the process of assessing these claims and has a number of legal and contractual defenses to each claim. No further provisions have been recorded for these claims. The Company will fully and vigorously defend itself. In addition, the Company continues to believe that any financial impact will be partially offset by insurance coverage. AGI is working with insurance providers and external advisors to determine the extent of this cost offset. Insurance recoveries, if any, will be recorded when received.

I had a massive due diligence failure, especially considering one of these two events was within a car ride of where I am. Fibreco sued Ag Growth International and also the professional engineer that signed off on it, in BC Supreme Court on June 4, 2021. There was also a news article on the matter which I totally missed.

This is probably the biggest contributor to the stock getting tanked over the past quarter. $190 million is close to $10/share, but the larger impact is the balance sheet threat.

Ag Growth relies a lot on low cost debt capital to fund its operations. Given the nature of its business, their cash flows are relatively predictable and there is a seasonality with cash collections that require the usage of credit. Their debt structure is funded by unsecured debentures (AFN.DB.D, E, F, G and H) each of which is around $86 million in quantity. The unsecured debt is termed out, with D and E maturing in June and December 2022, while the rest of them are out in 2024 and 2026. They also have some tranches of first-in-line bank debt as follows:

Note that they all term out in 2025 and there is about $95 million of availability on the Canadian revolver and $29 million on the CDN swing line.

However, all-in-all, given there is a total of $900 million of debt between these two series ($430 million of unsecured, and $470 million of secured, roughly at an average weighted cost of around 3.9%), the company’s leverage position is quite extended. Tacking on another $190 million on top of that is a tall order. An increase in the cost of capital, needless to say, will be adverse for the equity holders (a 1% increase in capital cost is about 50 cents per share, pre-tax).

The risk has definitely increased due to the number of unanswered questions.

1. How much will insurance actually cover, especially in the event that AFN is found to be at-fault? What is the maximum coverage? (God forbid if the majority of it was self-insured).
2. When will these proceedings resolve themselves (typically it will be by settlement, but a trial would take a couple years to clear out undoubtedly)
3. (by far, the biggest factor of these three, in my opinion) Because AFN screwed up (whether it is their fault or not, doesn’t really matter at this point) building two grain towers, are there any other towers of like composition that are waiting to crumble down?
4. Will re-financing risk be a factor (specifically with AFN.DB.D, and E)?

Question number 3 could literally be a case of waiting for another time bomb to go off, in the form of another grain silo collapse. Another such event would tank the equity by 20% in a day. This is a sort of unknown-frequency, high severity event that elevates risk.

On the flip side, we have the following:

1. The market for AFN’s unsecured debt is still strong (trading just slightly above par at the moment across the entire term) although the whole point of doing this market analysis is to determine when the market is wrong! That said, if there is some debt distress, it isn’t being reflected in these prices;
2. The company, at least on a basis when grain towers aren’t imploding, should be able to generate around $45 million in cash this calendar year, and in a more normalized year, should be able to generate north of $100 million and de-leverage. This is…
3. … fueled by the fact that agricultural products have had their supply chains really disrupted and the demand for product should create demand for capital spending on agricultural equipment.
4. Lawsuits, especially in Canada, very frequently settle for below the “face value” on the claim.

My last comment is that there was some premium valuation in AFN on the basis of “Ag Tech”, but it appears that this bubble has popped with Farmer’s Edge (TSX: FDGE) cratering (it’s down 75% since its IPO and indeed closer to where it should be trading!). This part is healthy.

The current dividend, at 60 cents per share, or $11 million a year, is not particularly onerous to maintain, especially in the case of ‘normal’ business performance, which should be a lot higher than what they have been doing in the past.

If the overhang on the stock is purely on the basis of this lawsuit, the stock is at a price level where it is attractive. If there are more structural issues with the industry that AFN is in, then my original investment thesis was flawed. I do not believe this to be the case, but definitely the elevation of risk is reflected in the stock price. I’m not happy with this situation, nor am I happy about how it was presented in the past few quarters.